Factor Investing and the Management of the Norwegian Sovereign Wealth Fund

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1 Factor Investing and the Management of the Norwegian Sovereign Wealth Fund Stephen M Schaefer London Business School investmentforum Salzburg 19 April 2018

2 GPFG: Performance Measurement in Norway s Government Pension Fund Global one of the two largest SWFs in the world (current MV assets ~ $950 Bn) Actively managed by Norges Bank IM (NBIM) under mandate set by the Norwegian Ministry of Finance (MoF) 60:40 equity/bond split (at the time) with essentially standard benchmarks ( slightly bespoke ). Fund returns for : 46 bps outperformance against benchmark with SD of tracking error of 38 bps: IR of : Study into management of fund (for MoF) with Andrew Ang and Will Goetzmann Follow-up studies: Ang, Brandt and Denison (2014), Dahlquist & Ødegaard (2018) Factor Investing and the Norwegian Sovereign Wealth Fund 2

3 Weights on Equity, Fixed Income and Real Estate Source: Review of Norges Bank s Active Management of the Government Pension Fund Global Dahlquist, M & Ødegaard, B.A., Factor Investing and the Norwegian Sovereign Wealth Fund 3

4 We studied active returns Active Actual Benchmark = Return Return Return Active returns are the result of active management Factor Investing and the Norwegian Sovereign Wealth Fund 4

5 How active is the GPFG? Our 2009 study found that the amount of active risk in the Fund was very small Variance Attribution Full Sample Pre-2008 Benchmark Return 99.1% 99.7% Active Return 0.9% 0.3% Total Return 100.0% 100.0% Factor Investing and the Norwegian Sovereign Wealth Fund 5

6 Question 1: what was the contribution of active management to returns? About two-thirds of the (small) variance of the active returns could be explained by a small number of systematic factors and, in particular, by Value, Liquidity and Volatility These exposures were not deliberate choices by fund sponsor but induced through active management styles of: internal managers; and about 150 external equity about 50 external FI mandates Factor Investing and the Norwegian Sovereign Wealth Fund 6

7 Question 2: What happened to the fund in the crisis? Factor Investing and the Norwegian Sovereign Wealth Fund 7

8 5 Overall Fund Cumulated Active Returns Factor Investing and the Norwegian Sovereign Wealth Fund 8

9 5 Overall Fund Cumulated Active Returns Factor Investing and the Norwegian Sovereign Wealth Fund 9

10 Most of the underperformance was in fixed income Source: Review of the Active Management of the Norwegian Government Pension Fund Global, Ang, Brandt & Denison, Factor Investing and the Norwegian Sovereign Wealth Fund 10

11 and smaller but still significant in equities Source: Review of the Active Management of the Norwegian Government Pension Fund Global, Ang, Brandt & Denison, Factor Investing and the Norwegian Sovereign Wealth Fund 11

12 Question 3: Do factors explain actual tracking error? The fund had a very large negative tracking error of around 500 bps in (~ $16 billion) the historical tracking error prior to the crisis had been around 40 bps (12 SD s) Does the fund s factor exposure combined with actual factor innovations help to explain the outcome? to some significant extent yes although some pre-crisis factor exposures difficult to estimate Factor Investing and the Norwegian Sovereign Wealth Fund 12

13 Overall Fund Active Returns Post Financial Crisis Source: Review of the Active Management of the Norwegian Government Pension Fund Global, Ang, Brandt & Denison, Factor Investing and the Norwegian Sovereign Wealth Fund 13

14 Main Finding of 2009 Report Active returns on the GPFG were affected by exposures to systematic factors over and above the exposures that were present in the benchmark Recommendation: that the Ministry of Finance (who set benchmark) should decide the level of factor exposure and that these exposures should be included in the benchmark Factor Investing and the Norwegian Sovereign Wealth Fund 14

15 Implications of Factor Exposure I: Performance Measurement While many factors are dynamic (e.g., value, momentum), factor exposure can be created relatively cheaply Active managers should be rewarded only for performance over and above the return on a portfolio with equal factor exposure e.g., active value manager should not be rewarded simply for generating exposure to the value factor Factor Investing and the Norwegian Sovereign Wealth Fund 15

16 Implications of Factor Exposure II: Fundamental Risk Characteristics Different factors have different risk characteristics (e.g., the extent of drawdown in a crisis) Choice of factor exposure should reflect fund characteristics This aspect of factor investing is important but poorly understood Factor Investing and the Norwegian Sovereign Wealth Fund 16

17 GPFG s Governance Structure and Benchmarks Factor Investing and the Norwegian Sovereign Wealth Fund 17

18 GPFG s Governance Structure Factor Investing and the Norwegian Sovereign Wealth Fund 18

19 Response of the Ministry Ministry of finance decided not to include strategic factor exposures explicitly in the benchmark MoF continuing with benchmark defined solely in terms of conventionally constructed indices of publicly traded equities and bonds But, in revision to mandate given to manager (NBIM), Ministry included references to factor exposure: the equity and bond portfolios shall be composed in such a way that the expected relative return is exposed to several systematic risk factors *. the Bank shall establish principles for the measurement and management of market risk, including relevant sources of systematic risk *. *Source: Ministry of Finance, Management Mandate for the GPFG, Revised 31-Aug Factor Investing and the Norwegian Sovereign Wealth Fund 19

20 Benchmark Framework Ministry: Benchmark expressed in terms of standard equity and fixed income benchmarks with adjustments for rebalancing rules that reflect scale NBIM: Operational Reference Portfolio Ministry benchmark adjusted for factor tilts scale and liquidity based opportunities for diversification beyond benchmark now report factor exposure of fund returns Factor Investing and the Norwegian Sovereign Wealth Fund 20

21 Operational reference Portfolio Addresses manager s view on risk-reward of various factors returns and risks aggregated Does not attempt to address relative suitability of exposures to different risk factors this issue is not often considered in the discussion of factor investing not well understood Factor Investing and the Norwegian Sovereign Wealth Fund 21

22 NBIM Now Reports Systematic Risk Exposures Example: fund exposure to market and 4 Fama-French Factors SMB: size HML: value/growth RMW: profitability CMA: investment Note: R-squared is low because F-F (Global) Market portfolio has very different weighting from benchmark portfolio Source: NBIM, Risk and Return Report, Factor Investing and the Norwegian Sovereign Wealth Fund 22

23 Summary Norway s GPFG has taken strategic decision that fund should have exposure to systematic risk factors Has delegated choice of factors and degree of exposure to manager (subject to overall risk limits) gives manager freedom to use factor exposure to boost Sharpe ratio Difficult question remains regarding economic character of risks and conformity with fund objectives Factor Investing and the Norwegian Sovereign Wealth Fund 23